Interesting. It turns out that bonuses don’t improve performance at all.

With all of the talk of Wall Street bonuses in the news lately, there’s a pretty interesting article in today’s Globe and Mail. Here’s an excerpt:

In 2008, Dan Ariely, a professor of behavioural economics at Duke University and the author of Predictably Irrational, led a series of experiments to determine exactly how people respond to financial incentives. Participants in the study were asked to play memory games, put together puzzles and perform physical tasks, such as throwing a ball at a target. When they performed very well, they earned a payout. Some subjects were promised a small bonus, about the equivalent of a day’s pay, while others were shooting for a much bigger reward.

Here’s what happened: For tasks that required no cognitive skill, such as repeatedly pressing the same key on a keyboard, performance improved when researchers upped the bonuses. But for tasks that demanded any intelligence at all (some participants played an electronic game of Simon Says), the incentives didn’t work. In fact, the bigger the bonus, the worse the performance.

Oops. It turns out that these giant bonuses the corporate executives like to reward themselves with are almost certainly worthless in terms of improving performance, and in fact they probably make their performance worse. In short, not only are the bonuses of Wall Street bankers outrageously offensive in light of their contribution to present economic woes (not to mention the fact that the taxpayers had to bail out their industry to keep it from collapsing last year), but that bonus culture might have even contributed toward the reckless and incompetent conduct that led to these woes in the first place.

Of course, we should not expect this perverse status quo to ever change. From the article:

Of course, many in the C-Suite already know that bonuses are bunk. In 2003, Harvard professors Michael Beer and Nancy Katz anonymously surveyed over 200 senior executives in more than 30 countries about their bonus plans. The overwhelming consensus was that bonuses had little or no effect on how their companies or employees performed. Many execs even admitted to low-balling expectations, to ensure everyone was eligible for a bonus.

And there’s the rub: You don’t hope for a bonus; you expect one. The first company to voluntarily scrap its bonus pool will undoubtedly watch as talent flocks across the street (right into the arms of Goldman Sachs, whose current $12-billion U.S. compensation kitty is the biggest it’s ever had). One might have thought a long and painful recession would have compelled companies to reconsider their most basic practices, but, this year, many will carry on as usual.

Goddamned bankers. I may not be a Christian myself, but I can see why Jesus hated them.

EDIT: here’s an excerpt from another article on the subject (this one from the CBC on November 4):

Chief executives in 35 of the top Fortune 500 companies were overpaid by about 129 times their “ideal salaries” in 2008, according to an analysis by a Purdue University researcher.

Venkat Venkatasubramanian, a chemical engineer, said he’s devised a new way to calculate the true worth of top CEOs based on equations found in chemical engineering.

His paper — What is Fair Pay for Executives? An Information Theoretic Analysis of Wage Distributions — was published Tuesday in the online open-access journal Entropy.

Fair pay for an average S&P 500 CEO should ideally be in the range of 8 to 16 times the lowest employee salary, according to Venkatasubramanian’s calculations.

By contrast, average CEO pay ratios were about 11-to-1 in Japan, 15-to-1 in France, 20-to-1 in Canada and 22-to-1 in Britain in 2006.

Since the 1970s in the United States, the ratio of CEO pay to the lowest employee’s salary has gone up to as high as 344-to-1 from about 40-to-1

That’s amazing. American business leaders continue to insist that stratospheric US executive pay is necessary in order to attract “top talent”, but one would be hard-pressed to conclude that US corporate executives are ten times more competent than their counterparts in Japan, France, Canada, or Britain. Is GM’s CEO ten times better than Toyota’s CEO?

7 Responses to Interesting. It turns out that bonuses don’t improve performance at all.

Interesting study. I’m glad that my initial beliefs were justified. Sadly my employer provides an excellent case study outside the financial sector. There has always been what I would term to be “dumb-ass-itis” displayed by the senior managers and executives but with our purchase by Textron (Ironically listed in the Top 10 companies most likely to go bankrupt by Forbes just a month or so ago,) a few years back, executive I.Q.s dropped dramatically by several points.

Just to give you a bit of insight into some of the problems that we have been facing I’ll explain what it is we do. We are primarily a defense contractor whose main focus is to provide engineering support services to DoD systems. As such…we rely on DoD contracts to remain in operation. Over the last two years, nine proposals have been drawn up in response to DoD requirements and ready for bid. Of those, only three were actually allowed by upper management to come to fruition and be submitted for bid. Then those same executives yanked back those same proposals at the last minute to include some dipshit cost point that completely altered the overall proposal. Needless to say that we lost. Wait…this gets even better. So as revenue slows down and hard-working folks get pink-slipped from both the field support division and the manufacturing plant, these jokers are wandering through their glass hallways shouting about the need to be proactive in order to indentify, prosecute, and obtain more business. I wouldn’t have believed that crap had I not heard it with my own two ears while I was up at corporate a few months ago after getting back from Afghanistan. You see, I’m one of those field guys that almost got cut which would be bad since I have a wife and dog to support. Luckily I have friends in low places and my boss goes out of his way to help me so I was able to remain gainfully employed. But I knew several others that did not get to remain employed despite my best efforts to get them attached somewhere else within the company.

I knew several people on that proposal team…my father being one of them. That team probably has somewhere in the realm of three centuries of combined experience in field technical support, engineering, operations, logistics, budgeting analysis, and customer relations. They all have 20-plus years on the job. Three have over 30 years. As former field personnel and site managers, they have intimate knowledge about running these type of contracts from the government’s perspective. They understand the true costs associated in terms of manpower, maintenance, parts, etc. They understand the technology better and know that is more expensive in both terms of money and manpower to maintain an antiquated, obsolete system with non-existent parts compared to a newer design less than five years old.

These guys stood by the fact that each contract would have been ours had the senior level folks not put their nasty dick-beaters on those proposals at the last minute virtually unbalancing the entire equation. This situation coupled with the fact that management continuously debates over what to do when folks who know and have played this game for many years take the initiative and work to develop new opportunities has resulted in a severe downward slide that may eventually result in the destruction of our entire division. The whole thing is positively Dilbertific.

Anyway, good information and I appreciate you sharing it. Great site…love the SWvST debates. Always have! Until next time.

What I forgot to add to this commentary is that while us poor feeble field personnel get our contract award fee bonuses cut…the senior people get salary increases and performance bonuses. They forget the fact that it by our blood, sweat, and…er…sore backs, that allows this company to function. If we were out here doing a shitty job, then we would not hold onto our contracts for very long.

Yes, that sounds all too familiar. No one in the executive suite is ever responsible for anything going wrong, are they? Without naming names, let’s just say I had a boss once who accused employees of “sabotaging” his great idea when it failed, and held meetings where he would harangue them for their failure to make his idea work. It never even occurred to him that maybe the idea itself was bad: oh no, it had to be the employees’ fault for “sabotaging” it.

In a market like the United States’, one ought to expect these inefficiencies. Free markets are ultimately efficient (as in Venkatasubramanian’s paper) through an iterative competitive process that kills inefficient businesses and rewards efficient ones. When there are only a few big firms in a market, there’s little competition to force businesses to trim fat like these bonuses. Moral of the story? Regulations are necessary somewhere, whether to keep businesses broken up and markets competitive, or to more directly curtail this sort of inefficiency.

On a related note, I remember reading recently about an auction of the art that had been decorating the walls of one of these big Wall Street firms that went under. We’re talking really rare, expensive pieces. How does any alleged enhanced productivity justify that sort of exorbitant expense? Really, the only way these can be explained is that the banks weren’t being forced to carefully watch their expenses.

Another thought: how many small business owners can afford to pay themselves relatively so well? It seems to me that someone running a small business in a competitive market who engaged in that kind of self-aggrandizement would go under in short order.

Also, in the name of technical correctness, I don’t know anyone who’d argue that 10x the pay implies 10x the performance; the argument would concede diminishing returns, instead insisting that whatever higher performance you get from the pay would be more valuable than performance gotten from using the money elsewhere in the company.

Interesting read. The disparity is quite large; at least there some good news that shows that the pay does correlate with higher performance. I don’t necessarily think all the CEOs deserve this much compensation but it’s not place to decide what they should earn, especially since I don’t work for the company. The board decides what is a good compensation package and hires the CEO to lead their company to economies of scale. Managing multiple aspects of a company that is globally competitive nowadays is not a simple thing. The CEOs don’t benefit at the expense of the workers unless they deliberately take their money. Finally, people should stop paying attention to the salary because it really isn’t a zero sum game

And what if the board members are friends with the CEO, as is often the case? In that case, it’s not a matter of “the board decides what is a good compensation package”; it’s more like “I’m going to do my good friend a nice favour”.

True. It’s not as if the system always operates perfectly. But this is beholden to many aspects of life. In the public sector for example, some workers were promoted to higher level management positions before others who had been doing the same job longer. Often this is because they have buddies or relatives who refer them to superiors as opposed to proving they have the credentials. People only pay attention to CEOs because of the large pay they make. I think it’s an issue when a corporation is going through a bad quarter and the CEO decides to fire people and increase his pay but beyond that, his fortune really isn’t my hardship.